Fed puts rates on hold

Thursday, March 28th, 2019

The US Federal Reserve acknowledges slowing economy and no rate rises for 2019

In a highly significant development for global markets, at the end of a two-day meeting in Washington, the US Federal Reserve decided unanimously to keep the target range for the Federal Funds rate between 2.25% and 2.5%, where it has been since December. More importantly, the Fed has signalled it will refrain from raising interest rates for the rest of the year in the face of waning economic momentum in the US and overseas, cementing a sharp, dovish shift in monetary policy led by Chairman Jerome Powell.

Whereas late last year the median interest rate forecast of Fed officials implied two additional rises in 2019, it now implies none, as US central bankers downgraded their expectations for US economic growth this year to 2.1% from 2.3% in December.

In its post-meeting statement, the committee characterized the labor market as “strong” but said the “growth of economic activity has slowed,” and recent indicators point to slower growth of household spending and business fixed investment in the first quarter. Furthermore, overall inflation has declined and in light of global economic and financial developments and muted inflation pressures, the Fed “will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate”. The Fed sees no rate hikes in 2019, and will begin in May to taper the amount of Treasury proceeds it allows to roll off its balance sheet each month and will end the program in September. The total of Treasuries and Mortgage Backed Securities once totalled more than $4.2 trillion and has been reduced by about $450 billion in the program that began in October 2017.

The implications are stark

The Fed leaving rates on hold for the year and allowing more credit to flow through the financial system means that the search for yield becomes all the more critical in a low interest rate, low inflation world. The obligation of Super Fund and SMSF Trustees to search out high-yielding securities has just become vastly more urgent. Bond yields are falling even further than the record low rates we have been experiencing to date, and the need to diversify into alternative asset classes which provide sustainable yield (whether interest, dividends, rentals, etc.) keeping in mind the risk of such exposure, becomes paramount.

Is the US about to go into recession?

Investors are being bombarded with charts from commentators that are designed to forecast the next US or world recession. Our first chart is an example of one that attempts to calculate the possibility that a US recession is coming in 2020.

The chart (like many) is fairly basic for it relies on the historic relationship between an inverted bond yield curve and subsequent economic growth. It suggests that when the US yield curve moves into negative territory (ie, inverts) then a recession will likely follow. The yield curve is negative when short-dated (or term) interest rates exceed longer dated (term) interest rates. Thus, if say two-year bond yields exceeded ten-year bond yields, then a negative yield curve is observed. Such a yield curve is normally created by Central Bank intervention when it lifts cash rates to slow an economy and check wages or demand-driven inflation.

Our next chart shows how close the Fed came to pushing the yield curve into negative. As the spread between 2 and 10-year bonds rapidly declined into 2018, the US equity market took fright (and suffered a 10% correction) and sent a clear warning to the Fed Open Market Committee to stop increasing cash rates – and they heard it!

While the world’s asset markets – particularly bond markets – are affected by manipulation and quantitative easing, should we totally dismiss the predictive power of the bond market? It has been observable since the end of the GFC (2009) that the world’s major bond markets have seemingly and persistently forecast deep recessions (if not outright depression). Negative yields (actual or real) historically suggested this.

Today over $9 trillion of government bonds traded through markets across the world have negative yields. Trillions more have small positive yields that are below the rate of inflation and are therefore trading with a negative real yield. Economic theory suggests that if long term market interest rates are negative, then we are in or approaching a serious recession.

Eurozone optimism has sunk to the lowest in almost six years during February. In the manufacturing sector, output expectations have dipped to the lowest since October 2012, while sentiment in the service economy is the weakest since October 2014.

Slowing economic growth and sustained low interest rates lead to some obvious conclusions – returns on investment assets are declining.

McKinsey forecasts lower returns

In a recent publication, McKinsey Partners noted the stellar returns from international equities and bonds since the GFC. In particular, they noted that bond returns were supercharged by QE and so bond returns over the last 30 years exceed 100-year returns by a significant margin.

Predictions are never easy to make but we can point to the observable fact that recent returns (particularly the last 10 years) have been bolstered by excessive stimulatory monetary policy. The returns on bonds have been exceptional, with significant capital gains generated as yields were driven to or below zero on long term bonds. Both US and European government bonds have generated returns well above long term averages. Thus, it is easy to suggest that average long term bond rates will normalise as the benefits of monetary policy become tired or exhausted.

McKinsey suggests that if the world endures a low growth cycle (consistent with our view), equity returns will be about 2% pa below long term averages. Future returns will only match the long term averages if world growth recovers strongly from the current anaemic outlook. For that to happen requires a significant co-ordinated fiscal stimulation program – something that is not even contemplated by world leaders outside China.

Our view

The world is moving deeper into a sustained low growth cycle that will be punctuated by mild downturns. This cycle will endure until governments and central banks co-ordinate growth policies in an even and consistent way across the world. In the meantime, China and, to a lesser extent India, will be the drivers of incremental growth as they attempt to grow per capita income for their large populations. Together, China and India constitute 36% of the world’s population of 7.7 billion people.

The challenge is to seek out high yielding assets, and build purposeful portfolios without materially increasing overall risk or excessive volatility.

Conclusion

It is difficult to escape the conclusion that dividends will be the most significant part of the forward returns expected from equity portfolios. Away from equities, cash yield (whether from property, fixed income or corporate debt) will be the most significant proportion of total returns for pension portfolios as a direct result of slowing economic and profit growth.

The last ten years was a period where PERs lifted and drove the major part of equity returns. This was a natural consequence of bond yields being driven down by QE. This, in turn, drove down the required earnings yield for equities, which meant that PERs expanded, and prices rose.Figure 3. Contribution to total return, past 10 years %, local currencySource. Thomson Reuters Datastream

Looking forward, we anticipate that the PER expansion cycle is over, although we do not see an imminent sharp fall in PERs as bond yields are still being checked by Central Banks. The Reserve Bank of Australia kept its official rate unchanged for the 31st consecutive month at its March meeting, signalling that it understands the new paradigm of “lower growth for longer” that we now find ourselves in.

How can we help?

Clime has been at the forefront of market commentators in appreciating the changing macro-economic environment. But far more important is the need to act upon this new reality, and adjust portfolios and asset allocations to match the opportunities available. Clime Private Wealth Advisers have a full range of asset opportunities available for building suitable portfolios for our clients – including high dividend yielding stocks, high yielding direct property opportunities, high yielding mortgage backed securities, commercial paper, hybrids, etc.

The Australian market still presents with some of the best yields available across the world, but investors need to accept slightly elevated risk. However, balancing this risk, it is our view that there is growth in the Australian economy – it may be historically low, but it is growth. Consult with your Clime Private Wealth Adviser now and ensure that your portfolio is fit for purpose – and appropriate for the new low rate environment in which we find ourselves.

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